MANUFACTURING’S NEW MATHCEOs juggle complex factors in calculating where to locate tomorrow’s factories

CEOs are rethinking their global manufacturing footprints, locating plants and R&D facilities as close as possible to major customers and preparing for a new wave of technologies that could transform the shop floor. To seize the future, they must persuade their organizations to experiment at a time when risk control is paramount.

Twenty years ago, about a dozen publicly traded industrial metal-cutting companies were headquartered in the United States. Today, Kennametal is the last survivor. While others failed, Kennametal transformed itself into the prototype of the modern global manufacturer, leveraging a world-spanning network of factories and research facilities.

Under the leadership of CEO Carlos Cardoso, the 75-year-old Pennsylvaniabased company does business in 60 countries and achieves slightly more than half of its US$3 billion annual revenues outside the United States. “We’ve done that not by standing still in the United States, but by growing the rest of the world at a faster pace,” Cardoso said.

The key to Kennametal’s success has been to follow large customers such as General Motors as they move into new markets. By being available where its customers are doing business – North America, Europe, China and India – Kennametal avoids losing them to local suppliers who then might emerge as global competitors.

Kennametal offshored, but not for offshoring’s sake. It remains a net exporter of high-technology, highmargin products.

SKILL INCREASINGLY TRUMPS WAGES

Like other best-in-class global manufacturers, Kennametal is engaged in a relentless push toward the high end of the technology food chain. It makes drill bits that operate 30,000 feet beneath the ocean’s surface and tools to cut the complex carbon fiber panels in the Boeing 787 Dreamliner.

“THE EQUATION FOR DECIDING WHERE TO LOCATE MANUFACTURING ON EITHER SIDE OF THE PACIFIC OCEAN IS SHIFTING.”

WILLY SHIHHARVARD BUSINESS SCHOOL

“There are two types of manufacturing,” Cardoso argues. “There is the low-labor-cost, high-volume, low- margin type of business that requires low skills. Those jobs are the jobs that have been mostly outsourced and offshored. Then there are high- technology, highly innovative, highly skilled, high-margin jobs. Those have tended to stay in developed economies.”

Leaders in China, a major beneficiary of offshoring, have noticed the same trend, especially as low-skill manufacturing has begun moving to countries with even cheaper labor. “We know we can’t keep relying on a low-cost competitive advantage,” Commerce Ministry spokesman Shen Danyang said in January. “We need to accelerate the value-added upgrading of our products” (see related article "China's Challenge").

For years, many CEOs thought China’s low wages were the answer to all their pricing challenges. Many, like Apple and Dell, outsourced the manufacturing of their most sophisticated products to third parties such as Singapore’s Flextronics and Taiwan’s Hon Hai.

Today, although factories in China remain crucial to satisfying exploding demand in the region, the value and utility of relying on factories 12 time zones away to make sophisticated products for North American and European customers is being questioned as never before.

“The equation for deciding where to locate manufacturing on either side of the Pacific Ocean is shifting,” said Willy Shih, a professor of management practice at Harvard Business School and co-author of the book Producing Prosperity: Why America Needs a Manufacturing Renaissance (see related article "Global Shift").

THE DOWNSIDE OF OFFSHORING

Deep structural forces help explain the shift. China’s currency has racked up double-digit gains, making it more expensive to export made-in-China goods. Labor costs are exploding by 25% to 30% a year. The Boston Consulting Group estimates that the costs of manufacturing in China will reach US levels by 2015.

In addition, long supply chains are slow to respond. Entrusted to the wrong people, important intellectual property can “leak” from companies that are not careful, and even from those that are.

Focusing exclusively on cheap labor also ignores the costs of coordinating far-flung operations and supply chains. CEOs are discovering that the feedback loops among customers, R&D and manufacturing are crucial for sustained innovation, so locating manufacturing close to R&D can be advantageous.

For example, 40% of what Kennametal sells is customized for specific end users. Six hundred Ph.D.s and engineers in nine research and development centers worldwide work to devise new materials, including tungsten carbide and industrial diamonds (see related article "Super Substances"). CEOs achieve the greatest profits and largest gains in shareholder value at this high end of the manufacturing ladder.

MADE IN THE USA

Seeking a new balance, several major American companies have announced the “backshoring” of manufacturing. NCR, for example, brought the manufacturing of advanced automated teller machines back to Georgia (USA) from China, partly because of the difficulty in coordinating its manufacturing with its design and software development, centered in the US.

Caterpillar, General Electric, Otis Elevator and Master Lock (see related article "Reshoring jobs") also shifted manufacturing from China and Japan to the United States. The backshoring moves haven’t reduced US unemployment and underemployment, in part because modern, backshored factories need smaller numbers of highly skilled workers to run them. Nor has the trend reduced the US trade deficit with China, which is still widening.

“MANUFACTURING IS GOING INDEPENDENT AND BREAKING RULES.”

SIR JAMES DYSONFOUNDER AND CHIEF EXECUTIVE OF DYSON LTD.

Even the toughest skeptics, though, agree that something has changed in how CEOs calculate the virtues of going offshore. “We’ve gotten past the blind offshoring from top management that was not based on any kind of rational approach,” said Ron Hira, associate professor at the Rochester Institute of Technology and co-author of the book Outsourcing America: What’s Behind Our National Crisis and How We Can Reclaim American Jobs.

CREATING REGIONAL “HUBS”

The debate in the United Kingdom and Europe is similar. CEOs are still willing to send labor-intensive manufacturing to Eastern Europe or Asia, but they are seeking to optimize their positions in high-level manufacturing at home.

“Improving technology, higher rates of production and shifting supply chains have intensified global competition, making it cheaper to produce products but harder to produce good ones,” said Sir James Dyson, founder of the US$1.5 billion company that bears his name. One-third of Dyson’s employees are engineers and scientists, helping the company continually innovate its vacuum cleaners, fans and hand dryers.

Dyson’s R&D investment has quadrupled over the past five years. As a result, Dyson is bullish that sophisticated manufacturing will rebound in the West. “Manufacturing is going independent and breaking rules, simplifying processes and cutting out the middle man through new forms of financing and production,” Dyson argues (see related article "The Voice of Experience").

Like their American and European counterparts, the developed economies of Japan and South Korea also want to pursue manufacturing’s high ground. For example, their parts represent a large percentage of the components found in US-based Apple’s products, which are assembled in China. Meanwhile, Korea’s Samsung Electronics has emerged as a tough competitor to both Apple and Japan-based Sony.

The emerging goal for all these companies is to create fully integrated research, design and manufacturing “hubs” in North America, Europe and China to serve buyers in each of those population centers, said Tom Mayor, a senior executive advisor at Booz & Co. in Cleveland, Ohio (USA), and a top expert on manufacturing. “Companies can keep shipping stuff across the Pacific Ocean, which doesn’t make much sense,” Mayor said. “Or they can put up a factory in the US and use up a lot of capacity to make stuff that they used to ship across the ocean.”

A RESHUFFLING OF THE GLOBAL DECK

If Mayor is right, all these shifts have major implications for China, where the government is consciously seeking to shed low-end, cheap-labor, dirty manufacturing, partly for environmental reasons. After only 30 years of basing their economy on inexhaustible supplies of pliant, affordable labor, China’s leaders are now seeking to make the transition to the high ground dominated by the world’s largest, most sophisticated companies (see related article "China's Challenge").

“YOU HAVE TO HAVE NERVES OF STEEL OR VERY BIG CONVICTIONS.”

ENVER YUCESANPROFESSOR OF OPERATIONS MANAGEMENT AT INSEAD, ON THE HIGH RISKS OF CHOOSING A FACTORY LOCATION

New technologies on the five- to ten-year horizon promise even more upheaval. One is 3D printing, in which products are created one layer at a time (see related article "3D Printing"). “It’s not just additive-layer manufacturing,” said Abe Reichental, president and CEO of 3D Systems in Rock Hill, South Carolina (USA). “It’s very powerful sensing, it’s infinite computing, it’s artificial intelligence and robotics. You put all that together with 3D printing and you have a very powerful convergence of enabling technologies that will allow for mass customization and for relocalization of distributed manufacturing.”

Reichental obviously has a stake in the success of 3D printing, but he has tapped into a powerful reality: companies are under increasing pressure to innovate faster, the complexity of product design is increasing, and the lifespans of many products are decreasing. All these factors are pushing the manufacturing balance away from supply chains that begin half a world away.

Add it all up and what appears to be happening is a great sorting out of which corporate functions – and which jobs – should be located in distant geographies. It amounts to a giant reshuffling of the deck, a process that may only accelerate.

BALANCING ACT

What is a CEO to do? These decisions are incredibly complex, requiring major commitments of capital, and the wisdom of each move may not be known for ten to 15 years. “If you have to put down US$1 billion, you have to have nerves of steel or very big convictions,” said Enver Yucesan, professor of Operations Management at INSEAD in Fontainebleau, France, who runs a five-day program for senior executives on Manufacturing in a Global Network.

Yucesan said that CEOs must become increasingly sophisticated in understanding where a product is in its lifecycle before deciding where to make it. For example, if a large Swiss company invents a molecule for a new herbicide, that molecule comes with built-in uncertainties. Can it be manufactured at the right price point and win regulatory approval? “In that case you want a plant close by with a lot of agility,” Yucesan said. “So maybe they start producing things in Switzerland with extremely high costs. They’d rather have the flexibility and pay a premium for it.”

If the Swiss plant proves that the product can be made efficiently and win new markets, the company then transfers the manufacturing to China or India. “These countries are not just imitators,” the professor said. “They are innovating on the process side. If it costs €35 a pound to make it in Switzerland, they can drive it down to €2.”

A CEO also must consider the productivity of different work forces, not just the raw cost of labor, Yucesan argues. The CEO’s list of considerations should include tax regulations, logistical constraints, access to ports and airports, the cost of doing business, and access to talent pools and skilled labor.

Increasingly, CEOs must ask where the best new ideas are emerging. “Is it a center of excellence for a particular skill set?” Yucesan said.

“Is there a unique capability in terms of universities or research organizations or government support for promoting certain kinds of development? Once you have all these parameters on the table, then the CEO has to make a decision. Anything less than that is incomplete.”

CULTIVATING RISKS WORTH TAKING

Of course, a CEO alone cannot possibly grasp all the factors in play, and so must create organizations that are networked across disciplines and geographies. But creating organizations that experiment and learn is difficult at a time when CEOs – and their boards – are hypersensitive about risk management and risk mitigation. It comes down to corporate culture.

Yucesan tells the story of a top German CEO who was frustrated that his direct reports weren’t innovating as aggressively as the CEO wanted. But his managers pointed out that the CEO was quick to criticize them for taking risks he believed were wrong.

Together with a psychologist, the CEO developed a formal scheme to manage the inherent tension. Each year, he gives his top managers three tickets. Then he challenges each manager to take risks, experiment, and report the results back to the board. “If you find me chewing you out,” he told his team, “you pull out one of the tickets. And you have to use at least two tickets each year.”

A bit contrived, perhaps, but the strategy addresses the central challenge that all CEOs face – creating global manufacturing organizations that are in the right places at the right time and that can see over the horizon to understand new technologies that will reshape their industries.

William J. Holstein is a New York-based business journalist and author. His most recent book is “The Next American Economy: Blueprint for a Real Recovery.” For more of his work, visit www.williamjholstein.com.